Inflation Outlook Supporting Treasuries As German Bund Yields Plunge

By Michael Aneiro

One of the main reasons the 10-year Treasury yield has fallen during 2014 instead of rising as expected is the even steeper plunge in the 10-year German bund yield, which is down to 0.94% Monday afternoon. While improving U.S. economic data should be pulling Treasury yields higher, all else being equal, the extra yield they offer compared to bunds is acting as an anchor on Treasury yields. Global investors would rather earn 2.4% a year in Treasuries than a lot less in bunds, and that ensures strong ongoing demand for Treasuries from overseas.

So given today’s global capital markets and the ability for funds to flow easily across borders, why have 10-year yields in Germany – Europe’s economic engine – still fallen by half a percentage more than comparable Treasury yields over the past year? The answer comes down to inflation expectations, according to Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott:

The European interest rate markets are telling us that, one, there’s a very high probability of low inflation or deflation that will last for years to come, and two, that the European Central Bank will be essentially impotent in generating enough inflation to break the Eurozone out of this current spiral…. [W]hat possible rationale would an investor have for buying Germany over the US? The answer comes down to inflation. If inflation is indeed falling in Europe while it’s stable or even rising in the US, the Euro currency will appreciate over time, and an investor measuring returns in USD-terms could actually find better returns from an EUR-denominated German 10yr. The performance hinges almost entirely on whether and how the ECB manages to stimulate inflation in the Eurozone, and our bet is that they’ll largely fail, which would be positive for bunds.

LeBas says the downward march of the German 10-year bund yield has been the most persistent of any developed market’s 10-year bond yield over the past year. He says the correlation between movements in bund yields and Treasury yields shows increasing synchronicity lately, except in the middle part of the yield curve where bund yields are already so low as to make further declines nearly impossible:

The correlation between 10yr Treasuries and 10yr bunds has been quite high of late, meaning that the markets are trading very much in synch— when bunds do well, Treasuries do well, and vice versa. Correlations tend to fluctuate over time, but the last four-to-five months have seen unusually persistent high correlations…. So long as long term German yields continue to fall—not a certainty, but a decent probability given the current trend—long term Treasury yields are likely to follow. That is not the case, however, with intermediate term yields, where the correlations, while rising, are relatively low. Part of the reason we’re not seeing the same relationship is that German 5yr yields are only 0.18%, while US 5yr yields are 1.65%. German yields simply cannot fall as far as US yields in that area of the curve, which alters the correlation math.

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.